Preparing a Budget

As a manager, you are expected to put together a budget for your department each year. Your compensation may depend, to a large extent, on your ability to stick to that budget. So it's in your best interest to create a realistic budget when you start out. Begin by setting goals. An ambitious manager wants to improve her division's performance over the previous year, increase net income for the company, or decrease costs—maybe even all three. How do you think your department can accomplish everything it has set out to do? That's where the budget comes into play. After all, a budget is a plan with numbers. Start with a list of three to five goals that you'd like to achieve—and put a completion date on them, too. For example: Increase gross sales by 5% by June 30th. Decrease administrative costs by 3% by end of fiscal year. Reduce inventories by 2% by the end of FY 99. Be sure you know the scope of the budget you're supposed to produce. Scope implies two things: the part of the company the budget is supposed to cover, and the level of detail it should include. The smaller the unit that you're focusing on, the more detail you need. If you're creating a budget for a 12-person sales office, you typically won't need to worry about such capital expenditures as major upgrades to the building or the computer equipment. But you should include estimates of what kinds of office supplies you'll need, and how much they will cost. As you move up the organizational ladder to include more people and larger departments in your budgeting, your scope broadens. You can assume that the head of the 12-person office has thought about paper clips and travel expenses. You're looking to convey the broad-brush outline, what the minute details of all the units' budgets add up to. Other issues to consider: Term. Is the budget just for this year, or the next five years? Most budgets are for the upcoming year, with quarterly or monthly reviews. Overview. Does your budget need to be accompanied by an overview of your strategic plan—for example, your plans for increasing sales or market share? If so, you need to be prepared to defend it. Take a hard look at your assumptions for the coming year. After all, a budget, at its simplest, takes current data, adds assumptions, and creates projections. Let's suppose you think sales will rise 10% in the coming year. If that's true, you may have to add two more people to your unit. But when you get before your budget committee, be prepared to defend your assumption that sales will rise 10%. Role-playing may help you here. Put yourself in the position of a division manager with limited resources and many departmental requests for funding. How can you make your case for two additional staff members so that the division manager grants your request ahead of all the others?

The Budget Process

A budget is a blueprint for achieving specific goals. Your unit's budget is part of your company's overall strategy. So you need to understand your company's strategy in order to create a useful budget.

How can you familiarize yourself with your company's overall strategy? Watch the overall economic picture. A company's strategy during a recession will be far different than in a booming economy. Make a point to listen to your manager's and colleagues' views on sales and the economy—and make your own observations as well. Are you deluged by résumés or is good help hard to find? Are prices rising or falling? Stay on top of industry trends. Even when the economy is booming, some sectors are going bust; your budget will need to reflect that reality. Steep yourself in company values. Every company has a culture, and the very best companies keep those values in mind during every decision. Suppose your budget calls for a cut in the company's contribution to health care plans. If the company's culture views such cuts as anathema to its overall commitment to employees, your proposal will be dead on arrival. Conduct SWOT analyses. Every company has strengths, weaknesses, opportunities, and threats. Keep them in mind as you build your budget. Top-down versus bottom-up budgeting If your company does top-down budgeting, senior management sets very specific objectives for such things as net income, profit margins, and expenses. For instance, each department may be told to hold expense increases to no more than 6% above last year's levels. It's left up to you to allocate your budget within the parameters to ensure that the objectives are achieved. For example, suppose Amalgamated Hat Rack decides that it wants to increase overall profitability by 10%. That could mean, among other possibilities, launching a new product line to generate new sales, or cutting overhead by upgrading technology, which would reduce the need for part-time workers. In addition, if your company does top-down budgeting, make sure to look at the overall plans for sales and marketing, as well as cost and expense plans, as you prepare your budget. The company's sales plan determines, to a large extent, how much money will be available for the budget. The marketing budget will give you an idea of what the company will be emphasizing in the coming year. Further, many companies that emphasize quality insist on reducing expenses every year, no matter how slightly, as a way to improve overall company quality. Thus, most major expenses—a new computer system, a new plant, a new field office—are carefully budgeted years in advance. In companies that do bottom-up budgeting, managers aren't given specific targets. Instead, they begin by putting together budgets that they feel will best meet the needs and goals of their respective departments. These budgets are then "rolled up" to create an overall company budget, which is then adjusted, with requests for changes being sent back down to the individual departments. This process can go through multiple iterations. Often it means working closely with other departments that may be competing against yours for limited resources. It's best to be as cooperative as you can with other departments during this process, but that doesn't mean you shouldn't lobby aggressively for your own unit's needs.

Other ways to assess financial health

Beyond profitability, operating, and leverage ratios, other ways of evaluating the financial health of a company include valuation, Economic Value Added (EVA), and assessing growth and productivity. Like the ratios described above, all of these measures are most meaningful when compared against the same measures for other companies in that particular industry. Valuation. Wall Street investors and stock analysts scrutinize a company's financial statements and stock performance carefully in order to arrive at what they believe to be a realistic estimate of that company's value. Since a share of stock denotes ownership of a part of the company, analysts are interested in knowing whether the market price of that share is a good deal relative to the underlying value of the piece of the company the share represents. Wall Street uses various means of valuation, that is, of assessing a company's financial performance in relation to its stock price. The earnings per share (EPS) equals net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company's financial performance. If it falls, it will likely take the stock's price down with it. The price-to-earnings ratio (PE) is the current price of a share of stock divided by the previous 12 months' earnings per share. It is a common measure of how cheap or expensive a stock is, relative to earnings. The price-to-book ratio is the current market price of a share of stock divided by a stock's book value per share. (To calculate the book value, subtract the preferred stock total from total equities, then divide the result by the number of shares outstanding.) Growth indicators. Growth measures can tell a great deal about financial health. A company's growth allows it to provide increasing returns to its shareholders, and to provide opportunities for new and existing employees. The number of years over which you should measure growth will depend on the business cycle of the industry the company is in. A one-year growth figure for an oil company—an industry that typically has long business cycles—probably doesn't tell you very much. But a strong one-year growth figure for an Internet company would be significant. Common measures of growth include sales growth, profitability growth, and growth in earnings per share. Economic Value Added (EVA). This concept was introduced as a way to induce employees to think like shareholders and owners. It is the profit left over after the company has met the cost of capital—the expectations of those who provided the capital. (Another way to describe cost of capital is that it is the weighted cost average to the company of acquiring debt and equity financing.)

Leverage ratios

Leverage has to do with a company's debt structure: the greater the component of long-term debt in the overall debt structure, the greater the financial leverage. The following measures help you determine whether your company's level of debt is appropriate and assess its ability to pay the interest on its debts. Interest coverage. This measures a company's margin of safety: how many times over the company can make its interest payments. To calculate interest coverage, divide earnings before interest and taxes by the interest expense. Debt to equity. This measure provides a description of how well the company is making use of borrowed money to enhance the return on owner's equity. To calculate the debt-to-equity ratio, divide total debt (long-term debt plus short-term debt plus current maturities) by total shareholders' equity.

Operating ratios

By linking various income statement and balance sheet figures, these measures provide an assessment of a company's operating efficiency. Asset turnover. This shows how efficiently a company uses its assets. To calculate asset turnover, divide sales by assets. The higher the number, the better. Days receivables. It's best to collect on receivables promptly. This measure tells you in concrete terms how long it actually takes a company to collect what it's owed. A company that takes 45 days to collect its receivables will need significantly more working capital than one that takes four days to collect. To calculate days receivables, divide net accounts receivable for the given time period by net sales, then multiply that quotient by 365. Days payables. This measure tells you how many days it takes a company to pay its suppliers. The fewer the days it takes, the less likely the company is to default on its obligations. To calculate days payables, divide accounts payable by the cost of goods sold for the period in question, then multiply that quotient by 365. Days inventory. This is a measure of how long it takes a company to sell the average amount of inventory on hand during a given period of time. The longer it takes to sell the inventory, the greater the likelihood that it will not be sold at full value—and the greater the sum of cash that gets tied up. To calculate days inventory, divide the average amount of inventory on hand for the period by the cost of goods sold for the same period, then multiply that quotient by 365. Current ratio. This is a prime measure of how solvent a company is. It's so popular with lenders that it's sometimes called the banker's ratio. Generally speaking, the higher the ratio, the better financial condition a company is in. A company that has $3.2 million in current assets and $1.2 million in current liabilities would have a current ratio of 2.7 to 1. That company would be generally healthier than one with a current ratio of 2.2 to 1. To calculate the current ratio, divide total current assets by total current liabilities. Quick ratio. This ratio isn't faster to compute than any other—it simply measures the ratio of a company's assets that can be quickly liquidated and used to pay debts. Thus, it ignores inventory, which can be hard to liquidate (and if you do have to liquidate inventory quickly, you typically get less for it than you would otherwise). This ratio is sometimes called the acid-test ratio because it measures a company's ability to deal instantly with its liabilities. To calculate the quick ratio, divide cash, receivables, and marketable securities by current liabilities.

Profitability ratios

These measures evaluate a company's level of profitability by expressing sales and profits as a percentage of various other items.

• Return on assets (ROA). ROA provides a quantitative description of how well a company has invested in its assets.
  To calculate ROA, divide net income by assets.
• Return on equity (ROE). ROE shows the return on the portion of the company's financing that is provided by owners.
  To calculate ROE, divide net income by owner's equity.
• Return on Sales (ROS). Also known as profit margin, ROS is a way to measure how sales translate into profit. For example, if a company earns $10 for every $100 in sales, the ROS is 10/100 or 10%.
  To calculate ROS, divide net income by the total sales volume.
• Gross margin. A ratio that measures the percentage of gross profit relative to sales revenue. Gross profit is profit or income after deducting the cost of goods sold. A decline in gross margin may signal that a company won't be able to meet its expense obligations. To calculate gross margin, first calculate gross profit by subtracting cost of goods sold from sales. Then calculate gross margin by dividing gross profit by sales.
• Earnings Before Interest and Taxes (EBIT) margin. Many analysts use this indicator, also known as operating margin, to see how profitable a company's operating activities are.
  To calculate the EBIT margin, divide net sales by EBIT.
  
  

Measuring Financial Health

By themselves, financial statements tell you quite a bit: how much profit the company made, where it spent its money, how large its debts are. But how do you interpret all the numbers these statements provide? For example, is the company's profit large or small? Is the level of debt healthy or not?

Ratio analysis provides a means of digging deeper into the information contained in the three financial statements. A financial ratio is two key numbers from a company's financial statements expressed in relation to each other. The ratios that follow in the next posts are relevant across a wide spectrum of industries, but are most meaningful when compared against the same measures for other companies in the same industry.

Comparing the Three Financial Statements

The three financial statements offer three different perspectives on your company's financial performance. That is, they tell three different but related stories about how well your company is doing financially. The income statement shows the bottom line: it indicates how much profit or loss a company generates over a period of time—a month, a quarter, or a year. The cash flow statement tells where the company's money comes from, and where it goes—in other words, the flow of cash in, through, and out of the company. The balance sheet shows a company's financial position at a specific point in time. That is, it gives a snapshot of the company's financial situation—its assets, equity, and liabilities—on a given day. Another way to understand the interrelationships is as follows: The income statement tells you whether your company is making a profit. The balance sheet tells you how efficiently a company is utilizing its assets and how well it is managing its liabilitiesin pursuit of profits. The cash flow statement tells you whether the company is turning profits into cash.

The Cash Flow Statement

A cash flow statement gives you a peek into a company's checking account. Like a bank statement, it tells how much cash was on hand at the beginning of the period, and how much was on hand at the end of the period. It then describes how the company spent its cash. As with a checkbook, uses of cash are recorded as negative figures, and sources of cash are recorded as positive figures. If you're a manager in a large corporation, changes in the company's cash flow won't typically have an impact on your day-to-day functioning. Nevertheless, it's a good idea to stay up to date with your company's cash flow projections, because they may come into play when you prepare your budget for the upcoming year. For example, if cash is tight, you will probably be asked to be conservative in your spending. Alternatively, if the company is flush with cash, you may have opportunities to make new investments. If you're a manager in a small company, you're probably keenly aware of the firm's cash flow situation, and feel its impact almost every day. The cash flow statement is useful because it shows whether your company is turning profits into cash—and that ability is ultimately what will keep your company solvent.

The cash flow statement doesn't measure the same thing as the income statement. If there is no cash transaction, it cannot be reflected on a cash flow statement. Notice, however, that net income on the cash flow statement is the same as the bottom line of the income statement—it's the company's profit. Through a series of adjustments, the cash flow statement translates this net income to a cash basis. In general, a company looks to three sources of cash: ongoing operations, investment activities, and financing activities. It's traditional to start with ongoing operations. Accounts receivable and inventory represent items the company has produced, but hasn't received payment for. Prepaid expenses represent items the company has paid for but has not consumed. These items are all subtracted from cash flow. Accounts payable and accrued expenses represents items the company has already received or used, but hasn't yet paid for. So these items add to cash flow. Investment activities can be cash the company uses to invest in financial instruments or plant, property, or equipment (such investments in PP & E are often shown as capital expenditures) gains realized from the sale of plant, property, or equipment gains realized from converting its investments into cash.

The Balance Sheet

Most people go to a doctor once a year to get a checkup—a snapshot of their physical well being at a particular time. Similarly, companies prepare balance sheets as a means of summarizing their financial positions at a given point in time. A balance sheet utilizes double-entry accounting—a system that ensures that each transaction balances. This system relies on the following basic equation: Assets = Liabilities + Owner's Equity. Assets are the things a company invests in so that it can conduct business—examples include financial instruments, land, buildings, equipment, and commodities. In order to acquire necessary assets, a company often borrows money from others or makes promises to pay others. Monies owed to creditors are called liabilities. Owner's equity, also known as shareholders' equity, is what, if anything, is left over after total liabilities are deducted from total assets. Thus, a company that has $3 million in assets and $2 million in liabilities would have owner's equity of $1,000,000. Assets = Liabilities + Owner's equity $3,000,000 = $2,000,000 + $1,000,000 By contrast, a company with $3 million in assets and $4 million in liabilities would have negative equity of $1 million—and serious problems as well. Thus, the balance sheet "balances" your company's assets and liabilities: the promises and agreements made with customers are balanced against the promises and agreements made with vendors and stockholders. It provides a description of how much, and where, the company has invested (its assets)—broken down into how much of this money comes from creditors (liabilities) and how much comes from stockholders (equity). Moreover, the balance sheet gives you an idea of how efficiently your company is utilizing its assets and how well it is managing its liabilities. Balance sheet data is most helpful when it's compared with information from a previous year. The balance sheet begins by listing the assets that are most easily converted to cash: cash on hand, receivables, and inventory. These are called current assets. Next, the balance sheet tallies other assets that have value but are tougher to convert to cash—for example, buildings and equipment. These are called plant assets, or, more commonly, fixed assets (because it's hard to move them). Since most fixed assets, except land, depreciate over time, the company must also include accumulated depreciation in this part of the calculation. Gross property, plant, and equipment minus accumulated depreciation equals the current book value of property, plant, and equipment. Here again, the balance sheet makes a distinction between short-term liabilities, also known as current liabilities, and long-term liabilities. Short-term liabilities typically have to be paid in a year or less; they include short-term notes, salaries, income taxes and accounts payable. Subtracting current liabilities from current assets gives you the company's working capital. Working capital gives you an idea of how much money the company has tied up in operating activities. Just how much is adequate for the company depends on the industry and the company's plans. For 1998, Amalgamated had $868,000 in working capital. Long-term liabilities are typically bonds and mortgages. Total assets must equal total liabilities plus owners' equity. Thus, subtracting total liabilities from total assets, the balance sheet arrives at a figure for the owners' equity. Owner's equity comprises retained earnings (net profits that accumulate in a company after any dividends are paid) and contributed capital (capital received in exchange for stock).

The Income Statement

You might want to invest in a company for many reasons. Perhaps it's a leader in the industry. Or its CEO has a great record of turning companies around. Or its products are on the cutting edge of technology. But if the company is not turning a profit, or doesn't show strong potential to become profitable over the medium term, you probably wouldn't want to invest in it. The income statement tells you if the company is making a profit—that is, whether it has positive or negative net income. (This is why the income statement is also called a profit-and-loss statement.) It shows a company's profitability throughout the year—typically, by presenting monthly, quarterly, and year-to-date summaries of the company's operations. In addition, the income statement tells you how much money the company spends to make that profit—that is, what its profit margins are. How does an income statement present this profitability picture? It starts with a company's revenues: how much money has come in the door from its operations. Various costs—from the costs of making and storing its goods, to depreciation of plant and equipment, to interest and taxes—are then deducted from the revenues. The bottom line—what's left over—is the net income or profit. Consider the following income statement for Amalgamated Hat Rack. Retail sales $ 2,200,000 Corporate sales $ 1,000,000 Total sales revenue $ 3,200,000 Cost of goods sold $ (1,600,000) Gross profit $ 1,600,000 Operating expenses $ (800,000) Depreciation expense $ (42,500) Earnings before interest and taxes $ 757,500 Interest expense $ (110,000) Earnings before income tax $ 647,500 Income tax $ (300,000) Net income $ 347,500 The cost of goods sold is what it cost Amalgamated to manufacture the hat racks. It includes raw materials, such as fiberglass, as well as direct labor costs. By deducting the cost of goods sold from sales revenues, we get a company's gross margin—the roughest estimation of the company's profitability. Operating expenses include administrative employee salaries, rents, sales and marketing costs, as well as other costs of business not directly attributed to manufacturing a product. The fiberglass for making hat racks would not be included here; the cost of the advertising would. Depreciation is a way of estimating the "consumption" of an asset over time, or of accounting for the diminishing value of equipment as time goes by. A computer, for example, loses about a third of its value each year. Thus, according to the matching principle, the company would not expense the full value of the computer all in the first year of its purchase, but as it is actually used over a span of three years. By subtracting operating expenses and depreciation from gross margin, we get operating earnings—often called earnings before interest and taxes, or EBIT. Interest expense refers to the interest charged on loans a company takes out. Income tax is levied by the government on corporate income. The bottom line—in this case, the net income is positive, thus indicating a profit—is what the for-profit company lives for.

Accounting methods

Financial statements follow the same general format from company to company. Depending on the nature of the company's business, however, specific line items may vary. Still, the statements are usually similar enough to allow you to compare one business's performance against another's. The reason for this similarity is that accountants abide by Generally Accepted Accounting Principles, or GAAP. Most companies use accrual accounting: Income and expenses are booked when they are incurred, regardless of when they are actually received or paid. This system relies on the matching principle, which helps companies understand the true causes and effects of business activities. Accordingly, revenues are recognized during the period in which the sales activity occurred expenses are recognized in the same period as their associated revenues. For example, at Amalgamated Hat Rack Co., which manufactures hat racks from imitation moose antlers, the revenue for a customer order is booked as each hat rack ships—even if payment is made on account and the cash is not received immediately. Similarly, if Amalgamated receives 2,000 brass hooks from a contracted supply company, those hooks are not all expensed at once. Rather, they are expensed on a per-unit basis: if it takes five brass hooks to make one hat rack, then the brass hooks are expensed five at a time as each hat rack is shipped out. Occasionally, a very small company will begin its existence using cash-basis accounting, which counts transactions when cash actually exchanges hands. This practice is less conservative when it comes to expense recognition, but sometimes more conservative when it comes to revenue recognition. But as companies increase in size and complexity, it becomes more important to match revenues and expenses in the appropriate time periods, so they tend to switch over to accrual accounting.

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Financial terms defined - O through Z -

Operating cash flow (OCF). The net movement of funds from the operations side of a business, as opposed to the investment side. OCF is usually described in terms of the sources and uses of cash. When more cash is going out than coming in, there is a negative cash flow; when more cash is coming in than going out, there is a positive cash flow. Operating profit (EBIT). The difference between the revenues of a company and the costs and expenses associated with conducting business. Also known as earnings before interest and taxes. Operating ratios. Financial measures that link various income statement and balance sheet figures to provide an assessment of a company's operating efficiency. Examples of operating ratios include asset turnover, days receivables, days payables, days inventory, current ratio, and quick ratio. Payback period. The length of time needed to recoup the cost of a capital investment; the time that transpires before an investment pays for itself. Pretax profit. Net income before federal income taxes. Price-to-book ratio. A method of valuation for stock, this ratio is calculated by dividing the current market price of a share of stock by the stock's book value per share. Price-to-earnings ratio (P/E). A common measure of how cheap or expensive a stock is, relative to earnings. P/E equals the current price of a share of stock divided by the previous 12 months' earnings per share. Productivity measures. Indicators such as sales-per-employee and net-income-per-employee, which link revenue and profit generation information to work force data, thereby providing a picture of employees' effectiveness in producing sales and income. Profitability ratios. Measures of a company's level of profitability, in which sales and profits are expressed as a percentage of various other items. Examples include return on assets, return on equity, and return on sales. Property, plant, and equipment (PP&E). A line item on a balance sheet that lists the value of a business's land, buildings, machinery, equipment, and natural resources that are used for the purpose of producing products or providing services. Purchase order. A written authorization to a vendor to deliver goods or services at an agreed upon price. When the supplier accepts the purchase order, it is a legally binding purchase contract. Quick ratio. A measure of a company's assets that can be quickly liquidated and used to pay debts. It is sometimes called the acid-test ratio, because it measures a company's ability to deal instantly with its liabilities. To calculate the quick ratio, divide cash, receivables, and marketable securities by current liabilities. Ratio analysis. A means of analyzing the information contained in the three financial statements, a financial ratio is two key numbers from a company's financial statements expressed in relation to each other. Ratios are most meaningful when compared to the same measures for other companies in the same industry. Return on assets (ROA). Expressed as a percentage, ROA is a quantitative description of how well a company has invested in its assets. To calculate it, divide the net income for a given time period by the total assets. The larger the ROA, the better a company is performing. Return on equity (ROE)/return on owner's equity. This measure shows the return on the portion of the company's financing that is provided by owners. It answers the question, "How profitable have management's efforts been?". To calculate ROE, divide the total income by total owners' equity. Return on sales (ROS). Also known as profit margin, ROS is a way to measure a company's operational efficiency—how its sales translate into profit. To calculate ROS, divide net income by the total sales volume. Sales. An exchange of goods and services for money. Sunk costs. Prior investment that cannot be affected by current decisions, and thus should not be factored into the calculation of the profitability of an initiative. SWOT analyses. An analysis of a company's strengths, weaknesses, opportunities, and threats. Time value of money. The principle that a dollar received today is worth more than a dollar received at a given point in the future. Even without the effects of inflation, the dollar received today would be worth more because it could be invested immediately, thereby earning additional revenue. Top-down budgeting. A budgeting process whereby senior management sets very specific objectives for such things as net income, profit margins, and expenses. Unit managers then allocate their budget within these parameters to ensure that the objectives are achieved. Valuation. An estimate of a company's value, usually for the purposes of purchase and sale, or taxation. Leverage ratiosand operating ratios provide means of evaluating and comparing companies' worth. Wall Street uses other ratios that describe a company's financial performance in relation to its stock price: earnings per share (EPS), price-to-earnings ratio (P/E), and price-to-book ratio. Working capital. A measure of a business's ability to pay its financial obligations, working capital equals the difference between a company's current assets (easily sellable goods, cash, and bank deposits) and its current liabilities (debt due in less than a year, interest payments, etc.). Shortages of working capital are often relieved by short-term loans.

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Financial terms defined - H through N -

Hurdle rate. The rate of return on investment dollars required for a project to be worthwhile. It is typically a higher rate of return than what would have been obtained by investing the capital in low- or moderate-risk financial instruments. Income statement. A report that indicates how much profit or loss a company generates over a period of time—a month, a quarter, or a year. In addition, the income statement, sometimes referred to as the earnings statement, tells how much money the company spends to make its profits. Interest coverage. This measures a company's margin of safety, or how many times over the company can make its interest payments. To calculate interest coverage, divide earnings before interest and taxes by the interest expense. Inventory. The supplies of the company that are or will become its product. Examples include the merchandise in a shop, the finished work in a warehouse, work-in-progress, and raw materials. Investment in PP&E. Dollars spent on Property, Plant, and Equipment. Sometimes called capital investment or capital expenditures. Invoice. A bill submitted to the purchaser, listing all items or services, together with amounts for each. Journals. The transaction records of the business. Leverage ratios. Ratios that assess a company's debt structure. The greater the component of long-term debt in a company's overall debt structure, the greater the financial leverage. These ratios, including interest coverage and debt to equity, help determine whether a company's level of debt is appropriate and assess its ability to pay the interest on its debts. Liabilities. The economic claims against a company's resources. Such debts include bank loans, mortgages, and accounts payable. Margin (%). Another term for profit, this equals revenues minus expenses. The margin is often expressed as the percentage by which revenues exceed expenses. Market price appreciation. The increase in the value of an asset over a specified time period. Market value. The value of an asset if it were to be sold at the current market price. Net book value (NBV). The value at which an asset appears on the books of an organization, minus any depreciation (usually as of the date of the last balance sheet) that has been applied since its purchase or its last valuation. Net income. The income of an organization after deducting the expenses, including interest and taxes, incurred in earning that income. Net present value (NPV). The economic value of an investment, calculated by subtracting the cost of the investment from the present value of the investment's future earnings. Because of the time value of money, the investment's future earnings must be discounted in order to be expressed accurately in today's dollars.

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Financial terms defined - E , F and G -

Earnings per share (EPS). One of the most commonly watched indicators of a company's financial performance, it equals net income divided by the number of shares outstanding. When EPS falls, it usually takes the stock's price down with it. Economic Value Added (EVA). The profit left over after a company has met the cost of capital—the expectations of those who provided of the capital. Equity. The value of a company's assets minus its liabilities. On a balance sheet, equity is referred to as shareholders' equity or owner's equity. Expenditure. An activity that results in an expense, or, the payment of cash for goods or services. This is a more specific term than "disbursement," which can include payments other than cash. Financial leverage. A company's long-term debt in relation to its capital structure (the total of its common stock, preferred stock, long-term debt, and retained earnings). A company that has consistently high earnings can afford to be more leveraged, that is, it can afford to carry more long-term debt than a company whose earnings fluctuate significantly. Financial statements. Reports of a company's financial performance. The three basic types of statement included in an annual report—the income statement, the balance sheet, and the cash flow statement—present related information, but provide different perspectives on a company's performance. Fiscal Periods. An accounting time period (month, quarter, year), at the end of which the books are closed and profit or loss is determined. Fixed vs. variable costs. Fixed costs remain constant despite sales volume; they include interest expense, rent, depreciation, and insurance expenses. Variable costs are incurred in relation to sales volume; examples include the cost of materials and sales commissions. General ledger. A company's centralized and authoritative accounting record, where balance sheet, income, and expense information for the period in question is summarized. Generally accepted accounting principles (GAAP). The rules and conventions that accountants follow in recording and summarizing transactions and preparing financial statements. Gross margin. A ratio that measures the percentage of gross profit relative to sales revenue. Gross profit. The sum left over after all direct product expenses or costs of goods sold have been subtracted from revenues. Growth. An increase in the value of a company's revenues, profits, or the value of its equity. Growth indicators. Measures that tell about a company's financial health. Common measures of growth include sales growth, profitability growth, and growth in earnings per share.

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Financial Terms Defined - D -

Days inventory. A measure of how long it takes a company to sell the average amount of inventory on hand during a given period of time. The longer it takes to sell the inventory, the greater the likelihood that it will not be sold at full value—and the greater the sum of cash that gets tied up. To calculate days inventory, divide the average amount of inventory on hand for the period by the cost of goods sold for the same period, then multiply that quotient by 365. Days payables. A measure that tells how many days—based on balance sheet and income statement data—it actually takes a company to pay its suppliers. The fewer the days it takes, the less likely the company is to default on its obligations. To calculate days payables, divide accounts payable by the cost of goods sold for the period in question, then multiply that quotient by 365. Days receivables. A measure that tells you in concrete terms—based on balance sheet and income statement data—how long it actually takes a company to collect what it is owed. A company that takes 45 days to collect its receivables will need significantly more working capital than one that takes four days to collect. To calculate days receivables, divide net accounts receivable for the given time period by net sales, then multiply that quotient by 365. Debt. What is owed to a creditor or supplier. Debt is sometimes referred to as notes payable or bonds payable. Debt to equity. This measure provides a description of how well the company is making use of borrowed money to enhance the return on owner's equity. To calculate the debt-to-equity ratio, divide total debt (long-term debt plus short-term debt plus current maturities) by total shareholders' equity. Depreciation. A way of accounting for the diminishing value of an asset as time goes by. Direct vs. indirect costs. Costs that are directly attributable to the manufacture of a product—for example, the cost of plastic for a bottling company. Direct costs vary in direct proportion to the number of units produced. Indirect costs cannot be directly attributed to a particular product—for example, the cost of machines that are used in the production of more than one product. Dividend. A payment (usually occurring quarterly) to the stockholders of a company, as a return on their investment.

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Financial terms defined - C -

Capital expenditure/capital investment. The payment required to acquire or improve a capital asset. Cash-basis accounting. An accounting process that records transactions when cash actually exchanges hands. This practice is less conservative than accrual accounting when it comes to expense recognition, but sometimes more conservative when it comes to revenue recognition. Cash flow statement. A review of a company's use of cash, this statement tells where the company's money comes from, and where it goes—in other words, the flow of cash in, through, and out of the company. Cash utilization/cash flow measure. The changes that affect a cash account during an accounting period. Chart of accounts. A way to outline the accounting system of a business, the chart of accounts establishes how the business will operate, what information will be captured, and what information will subsequently be readily retrievable by the system. It includes such items as inventory, fixed assets, accounts receivable, and costs. Cost of capital. The costs of different types of capital, including short-term debt, long-term debt, and equity. This cost is typically expressed as a percentage of the underlying capital. Cost of goods sold (COGS). The total cost paid for the products sold during the accounting period, plus freight-in costs. Most small retail and wholesale businesses compute cost of goods sold by adding the value of the goods purchased during the accounting period to the value of the beginning inventory, and then subtracting from that figure the value of the inventory on hand at the end of the accounting period. For manufacturers, cost of goods sold includes, in addition to raw materials, the direct cost of manufacturing labor (including Social Security and unemployment taxes on factory employees), and overhead charges such as supervision, power, and supplies. Cost of services (COS). Charges billed to a customer for a service. Overhead is often included in the calculation of the cost of services. Costs and expenses. The costs related to running the business—for example, salaries, office overhead, light, heat, legal and accounting services. Current assets. Those assets that are most easily converted into cash: cash on hand, accounts receivable, and inventory. Current ratio. This is a prime measure of how solvent a company is. It's so popular with lenders that it's sometimes called the banker's ratio. Generally speaking, the higher the ratio, the better financial condition a company is in. A company that has $3.2 million in current assets and $1.2 million in current liabilities would have a current ratio of 2.7 to 1. That company would be generally healthier than one with a current ratio of 2.2 to 1. To calculate the current ratio, divide total current assets by total current liabilities.

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Financial terms defined - B -

Balance sheet. A means of summarizing a company's financial position—its assets, equity, and liabilities—at a specific point in time. According to the basic equation in a balance sheet, a company's assets equal its liabilities plus owner's equity. Balance sheet data is most helpful when compared with information from a previous year. Banker's ratio. See current ratio. Book value. The value at which an asset is carried on a balance sheet. The book value of equipment is reduced each year for depreciation. Therefore, the book value at any time is the cost minus accumulated depreciation. Bottom-up budgeting. A process whereby managers put together budgets that they feel will best meet the needs and goals of their respective departments. These budgets are then "rolled up" to create an overall company budget, which is then adjusted, with requests for changes being sent back down to the individual departments. Breakeven. The volume level at which the total contribution from a product line or investment equals total fixed costs. To calculate the breakeven volume, subtract the variable cost per unit from the selling price to determine the unit contribution, then divide the total fixed costs by the unit contribution.

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Financial terms defined - A

Accounts payable (A/P). Money owed by the firm to agencies and suppliers. Accounts receivable (A/R). Money owed to a company for goods or services sold. The figure is important in determining a business's ability to meet its financial obligations. Accrual accounting. An accounting method whereby income and expenses are booked when they are incurred, regardless of when they are actually received or paid. Revenues are recognized during the period in which the sales activity occurred; expenses are recognized in the same period as their associated revenues. Accruals. An amount incurred as an expense in a given accounting period—but not paid by the end of that period. An example would be the electricity bill for a given quarter. Activity-based costing (ABC). An approach to cost accounting that focuses on the activities or cost drivers required to produce each product or provide each service. ABC assumes that most overhead costs are related to activities within the firm and that they vary with respect to the drivers of those activities. Allocation. The process of spreading costs from one expense category to several others, typically based on usage. For example, such corporate overhead expenses as rent and utilities may be charged to departmental units based on square feet. Amortized expenses. The costs for assets such as buildings and computers, which are depreciated (expensed) over time to reflect their usable life. Assets. The economic resources of a company. Assets commonly include cash, accounts receivable, notes receivable, inventories, land, buildings, machinery, equipment, and other investments. Asset turnover. A measure of how efficiently a company uses its assets. To calculate asset turnover, divide sales by assets. The higher the number, the better.

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Understanding Financial Statements

Companies do many things: build cars, process data, provide services, even launch satellites. But the underlying purpose of all for-profit companies is to make money. As a for-profit manager, your job is to help the company make money—preferably, more money each year. Even if you work in the nonprofit or government sectors, where net income is neither the only nor the most important bottom line, it is still vital that you carefully monitor how much money comes in and where it gets spent. You can help your company make money by reducing costs, increasing revenues, or both. The best managers don't just mind the budget—they look for the right combination of controlling costs and improving sales. How's your company's financial health? Where does its revenue come from, and where does it spend its money? How much profit is it making? Companies provide answers to such questions in three documents, called financial statements: the income statement, the balance sheet, and the cash flow statement. Publicly traded companies make these statements available to everyone—shareholders, industry analysts, and competitors as well. As a result, they are not as detailed as the company's internal financial statements.

How do I deal with rumors that are damaging morale?

The only way to stop rumors is with the truth. It is important that management be very candid and that it make available to employees, and others, truthful information in a timely fashion. This can be done with Web sites, telephone call-ins, taped messages, memos, etc.

What if I discover that a capable and loyal employee has violated the law and done so thinking that it would be in the interest of the company?

The violation should be disclosed immediately to at least the legal department and generally to the authorities. The company can provide the employee with good outside legal assistance, but a firm can never condone any form of violation of the law, no matter how well intentioned.

Should I disclose possible problems (to the public, my boss, my colleagues) if I am not certain that they are real problems or if there is a possibili

In general, it is best to disclose even potential problems. Although one does not want to make a habit of crying wolf, it is much worse to surprise others when problems do become serious. Furthermore, when problems are disclosed, your company may be able to find a way of avoiding them.

What if my boss wants to cover up a problem?

First, talk to your boss. If that doesn't work, get a new job or blow the whistle, or both. If your boss is trying to cover up a problem, then you will either become part of the cover-up, or you will appear to be part of it. You could even become the fall guy, the person who is blamed. In any case, your reputation will be damaged and you will suffer serious repercussions. Reveal the cover-up and/or get out.

Managing Yourself During the Crisis

Managers can show themselves as true leaders during a crisis. How do leaders handle themselves during a crisis? How do they handle their uncertainty and fear? They use the energy they derive from their feelings to face the crisis and deal with it as effectively as possible.

Dealing with a short-term crisis

If the crisis flares up and is over quickly, then try these simple steps to maintain your own emotional balance.

1. Stop. As soon as you begin to feel the first rush of anxiety flooding your mind, say "Stop!" to yourself. Say "Stop!" out loud. Repeat the message two more times. To face a crisis, you need to have a clear mind as unclouded by anxiety, toxic stress, and fear as possible. Thus, recognizing those feelings and verbally pushing back can block them from controlling your mind and actions.
2. Breathe. Take a deep breath. Hold that breath for eight seconds, and then slowly let the air out. Just as the word "stop" blocks the negative thoughts from your mind, breathing overcomes the stress-induced tendency to hold your breath.
3. Reflect. By interrupting the pattern of toxic stress and giving yourself energy through breathing, you can now focus on the real problem, the crisis you face. By reflecting on your stress response, you can begin to distinguish the different levels of thought and to sort out reasonable from irrational stress responses. You can see the practical situation more calmly and realistically and distinguish it from the distortions of your anxiety-influenced thoughts.
4. Choose. Finally, with your attention now on the practical situation itself, you can choose to find real solutions, follow the crisis plan your group has developed, and tend to the needs of the people you lead.

Dealing with a long-term crisis

You may have to handle another kind of crisis—one that starts as a slow burn and then breaks out into a wildfire of trouble. For example, financial crises often start as small problems in receivables, or perhaps cash flow fluctuations, and then build to an inability to borrow or cover basic expenses. You may have a sense of the emerging crisis for several weeks or months, yet you're unable to stop the spread of trouble.

In this case, when you're coping with stress over long periods of time, taking care of yourself becomes even more important. Long-term stress can be toxic—physically harmful to you.

Taking care of yourself gives you the strength and stamina to take care of the impact of the crisis. So even when you feel hemmed in by the growing crisis, remember to

• talk to people—don't become isolated
• get enough sleep
• exercise regularly
• eat a balanced diet
• avoid alcohol, caffeine, or sugar
• take a break whenever you can
• find humor wherever you can

Learning from the Crisis

When you make it through a crisis, don't just try to forget about it. Rather, take the opportunity to learn from the experience and make changes to avoid or prepare for another similar crisis.

Engineers use earthquakes as a learning experience to plan for stronger roads, bridges, and buildings. They use massive floods to determine the best ways for people to adapt to (build dams or dikes) or yield to (move out of a flood plain) the power of nature.

An organization, too, can do a post-crisis audit to learn and even profit from the event.

For example, when everyone in the catalog company mentioned earlier worked overtime to fill a large volume of orders they hadn't expected to receive, they successfully handled the immediate crisis. But operating in crisis mode is an ineffective way to work all the time (even though some businesses don't seem to think so). It takes its toll on morale, turnover, and the health of everyone, especially the manager. After the rush at the catalog company, everyone was given large bonuses and extra vacation time. Then management took steps to plan for the next year, so the company would be prepared to meet a large demand—with less pressure on the employees.

Review how the crisis was handled

Plan the timing of the crisis review soon enough after the event so that people remember details, but long enough for some emotional healing to have taken place.

Analyze the crisis from beginning to end. Pinpoint actions, assumptions, and outside factors that precipitated the crisis. Ask yourself the following questions:

• Knowing what we knew then, could the crisis have been prevented? How?
• At what point did we realize we were in a crisis? Could we have recognized the signs earlier?
• What warning signals went off that we may have ignored?
• What warning signals did we pay attention to?
• What were the early signs? Why were they turning points?
• What did we do right? What could we have done better?
• What were the stress points in the system that failed?

Look and plan ahead

Knowing what you know now, how can you prevent the same type of crisis from occurring again? Create a plan so that you learn from what you know.

Get input from everyone. You need to get everyone's story, but pay attention in particular to those with expertise in the areas of importance. If the crisis was technological, then listen to the computer experts, the IT group, the network engineers. If the crisis was relational—a critical vendor cuts off your supply of goods—talk to your buyers, but then get out in the field and find out what happened and why.

For example, the management of the catalog company listened to its employees and to outside consultants. Consultants analyzed workflow, looked at bottlenecks and technology. And everyone in the company who had worked in the warehouse to help get through the crunch now understood first-hand how the business was run. Their experience had taught everyone a great deal. The CEO set up a system to tap into the cumulative knowledge of everyone in the company. A suggestion program was implemented, and many suggestions were put into practice. A $100 reward was given each quarter to the employee who came up with the best idea.

Incorporate the ideas and information in your next round of strategic planning. You've already performed your first crisis audit; now, you'll have much more knowledge to improve the revised audit and the crisis-prevention plan.

Track results

Track the results of changes you make in the wake of the crisis. How are they working? Will they actually reduce the negative impact of a future event?

Resolving the Crisis

By definition a crisis requires fast, confident decision making. But how do you make good decisions when events are moving quickly? During times of confusion? When it's hard to sort out what's important and what isn't? How can you stay on track?

Be aware of the effects of stress

Typically, three emotions can combine to create the stress you feel during a crisis:

• fear of disaster
• anticipation of a potentially positive outcome
• desire for the crisis to be over

Under stress, you feel the pressure to make a decision. But the pressure can push you to a state of panic where you are making decisions solely to be "doing something." In reality, however, you are dispersing energy and resources—and this energy is your source of strength. Use the power of positive stress to handle the crisis as a confident leader.

Avoid toxic stress responses. Often people respond to these natural and conflicting feelings of fear, hope, and despair in ways that can aggravate—rather than relieve—the crisis.

Be sure to avoid these common ineffective and often harmful responses.

• When in doubt, scream and shout. The noise may seem as though the manager is doing something, but it is a waste of energy and fails to lessen the crisis situation.
• Hide your head in the sand. At times, the pressure to act becomes so stressful, a manager slips into a state of paralysis and can't make any decisions at all.

The leadership role

Whether acting as the CEO of a large corporation or a supervisor of a department, an effective leader finds out as quickly as possible what the real problem is. Often in a crisis, there will be a flurry of information, most of it inaccurate. It's your task to discover the truth and face it by asking the right people, listening to the most reliable voices, and going to the right places.

A leader in a crisis responds by

• facing the crisis—turning fear into positive action
• being vigilant—watching for new developments and recognizing the importance of new information
• maintaining focus on the priorities—ensuring that people are safe first, and then assessing the next most critical needs
• assessing and responding to what is in his or her control and ignoring what is not

Act. Once you understand the problem, there are really probably only a few realistic options open to you. If you have a crisis plan in place, use it.

Work together. A leader has the power to draw people together to act as a team. If your people know you are in charge, they will respond to your direction.

For example, when a catalog retailer that offered a large number of custom products—monogrammed bags, sweaters, and so forth—put out its holiday catalog, it was shocked by the positive response. From the moment the catalog was released in October, its phone lines were swamped. The company hired temporary help to work the phones, but still had a tremendous bottleneck: customizing and shipping the products. It was the holiday season. The head of distribution recognized that if they didn't get everything shipped in time for Christmas, there might not be a next season.

So the CEO put out a call for help and recruited management and administrative staff to work in the warehouse in the evenings—after they had done their regular jobs. Everyone worked together for six long and grueling weeks—everyone from the top down. By working as a team, the whole company eventually enjoyed astonishing success by growing 80% in that one year. What could have been a crisis and failure was turned around by teamwork.

Avoid blaming others. As the crisis heats up, the impulse to blame people can become irresistible. Certainly, a team member's incompetence or serious error may have caused the crisis, or may be perpetuating it. However, during the heat of the crisis, trying to find a scapegoat is counterproductive. Focus your people on handling the crisis, not on blaming others.

Later, after the crisis, it will be up to you to analyze whether or not a person should be reprimanded in some way. However, keep in mind that constant fault-finding lowers morale and stifles the creativity and commitment you need to solve the problem. Create an atmosphere where people look forward to what needs to be done, not backward to who was at fault.

Do what needs to get done. Rules, policies, structures, procedures, and budgets are created to maintain order and provide a productive process in the normal course of business. But most rules were not created with a crisis in mind. Do whatever has to be done, and don't worry about the "rules"!

Containing the Crisis

When a crisis does strike, the first thing you must do is contain it. Your goal is to stop the hemorrhaging fast. You must make decisions quickly. Be on the scene. Your physical presence is important. It lets everyone know that your company cares about what is happening. And you must communicate critical information to key people.

For example, when a supermarket chain was accused by major TV network of selling spoiled meat, the value of its stock plummeted. But the management team responded quickly. They gathered the facts by not only listening to the news media and hearing the message from stockholders but by paying attention to and working with their own employees as well.

They immediately stopped the practice of selling less-than-fresh meat, and they put large windows in the meat-preparation areas so the pubic could watch meat being packaged. They expanded their employee training, gave public tours of their facilities, and offered consumer discounts to draw people back into the stores. The company eventually earned an excellent rating from the Food and Drug Administration and sales returned to normal.

Be decisive and compassionate

When a torrential rain flooded a section of a building, the water destroyed computers, carpeting, paper records, and the workspace of 10 employees. The manager was on the scene as the workers showed up in the morning to help workers and direct immediate clean-up efforts. Later, after the clean-up, workers began having breathing problems and headaches. Though the carpet had been cleaned, it was determined that it was probably infested with mold. Instead of trying to clean the carpet again, or waiting for budgetary approval, the manager immediately ordered all the carpet in the area be removed and replaced.

Make decisions. This manager demonstrated two essential qualities necessary in a crisis—decisiveness and compassion. First, his presence on the scene showed that he, and the company, cared. Later, his decisiveness in replacing the toxic carpeting demonstrated that the health of employees was more important than any other consideration.

Decisiveness is not always easy, but it is important. Often you have to act on too little or inexact information. If there is no workable contingency plan in place, if there are no guidelines for the situation, and if there are no trusted confidants, there is still always your conscience. Ask yourself, what is the right thing to do? And then do it, hoping it is the right thing!

Respond to your people. Compassion is a part of many organizations' cultures, and it is typically rewarded in those cultures. But not always. Some companies pride themselves on having a ruthless and competitive culture. Nevertheless, a manager still has the power to set the tone for his or her own division. No manager—regardless of the corporate culture—has to abandon compassion or humanity, especially during a crisis.

Go public

Anyone who is handling a crisis is going to have to communicate with others. This could be the general public, or your immediate vendors, suppliers and clients. In any case, you will need to communicate to your team how the crisis will impact them and what they need to do. What you say and how you say it are critical. You are managing the perceptions of people whose reactions can drastically affect what happens. The way you communicate can precipitate actions that can make the crises worse—or better. A crisis, by definition, means that there is bad news. Dealing with pain and anger early on can forestall far worse problems later on. Your goal is to contain the overall crisis, not to make the present moment easier.

Expect rumors and false information. During a crisis, people want information—true or not. Use the communication plan you've developed as part of your crisis planning to address and stop the flood of false news.

Notify key people. Inform anyone who needs to know—company management, customers, employees, suppliers, government authorities—and do so quickly, within two hours, if possible. If you have created a communications plan or list of important phone numbers, now is the time to use it.

Stick to the facts. Whether you're talking to co-workers, authorities, or the media, make your message straightforward and honest.

Avoid these typical, but inappropriate messages:

• "No comment."
• "We haven't read the complaint."
• "A mistake was made."

As Warren Buffet made it clear in the quote above, give all the facts that you know. You are not obligated to speculate, or to cover-up because lying and speculating will only damage your credibility and your company's credibility if and when you are proven wrong.

Communicate all the bad news at once. It's like pulling off a sticky bandage. It will hurt now, but it will be over soon.

Communicate honestly. If you don't communicate honestly and openly, you will likely face a host of dangers.

• People will think you have something to hide and resent it. They'll keep digging, and when they find out what's going on, they will blame you.
• People cannot act effectively unless they as fully informed as you are.
• People will not be fully behind you if they do not understand the problem. You need as much support as you can get!

Recognizing the Crisis

The CEO of a major corporation was alerted one day that the president of one of its subsidiaries—a film company—had been accused of embezzling money and forging checks. But the CEO refused to believe that the film-company president would ever commit such crimes. He ignored the problem, but it didn't go away. By the time the CEO decided to fire the president, the charismatic thief had gotten board members lined up on his side. The board insisted on keeping the president. The situation worsened, with reports coming out in the paper tarnishing the name of the film company, the corporation, and all involved—including the CEO. It was an ugly, painful crisis, and one that could have been completely avoided had it been recognized as a potential crisis and dealt with promptly.

Like the CEO, many managers don't want to face unpleasant situations. Unfortunately, unpleasant situations can be signs of an impending crisis.

Is it a crisis?

Pay attention to that voice inside you that says "Uh-oh, there's something wrong!" The CEO must have been very disturbed when he found out that his film-company president was accused of embezzling. But he rationalized the event by telling himself that what he had heard was impossible.

On a day-to-day basis, managers learn of many disturbing facts and events. Instead of trying to ignore them, rationalize them, or minimize their importance, turn around and face them. Take a minute to step outside yourself and question the event and its consequences.

Characterize the event. If you answer yes to any of the following questions, you are probably dealing with an impending crisis.

Has the event caused—or does it have the potential to cause

• injury to any person?
• a threat to health or safety of any person?
• a threat to the environment?
• a breakdown in your company's ability to serve customers or to do business?
• a serious threat to employees' morale and well-being?
• a loss of data?
• a breakdown in your company's ability to communicate?
• potential damage to your company's reputation?
• serious financial loss?
• a legal action against your company or an individual associated with it (employee, subcontractor, partner)?

Evaluate the size of the crisis. Once you've realized that you are dealing with a crisis, you need to determine its scope and magnitude. Quickly gather as much information as you can.

Ask yourself questions such as the following:

• How many people are involved? Who are they?
• How long is this likely to last?
• Have any laws been broken? If yes, which ones?
• Who already knows about the crisis? What do they know?
• Who needs to know?
• What are the costs already in terms of health? Money? Reputation?

Self-reflect. Evaluate how you manage the situation. Are you someone who tends to underreact? Maybe you need to become more concerned. Or do you have a tendency to overreact? You may need to calm down. If you have time, talk over the event with someone you trust to check the validity of your reaction.

Consider your values. What is important? What is the right thing to do? For example, if an employee is breaking the law—and using the company to do it, what is your responsibility? Or, if a subcontractor is disposing of toxic waste from your company illegally, harming the environment, and possibly endangering lives, and you suspect the company is turning a blind eye to it, what should you do? Who is ultimately responsible when carcinogenic chemicals are found in a community's water supply?

How will you deal with the crisis?

You know you have a crisis on your hands. What do you do? You may have to deal with some aspects of the crisis immediately, but you will also need to come up with a flexible plan for dealing with the crisis' short- and long-term effects.

Get a team in place. You will need to get your crisis-management team in place as quickly as possible. Depending on the scope, members of the team may need to be assigned to the crisis full-time. If the crisis is big enough, or of long enough duration, you may need to pull the crisis-management team off some or all of their regular duties.

If you have performed a crisis audit, then your team members will already know what their roles are and how to communicate with each other.

Get the information you need. Throughout the crisis, you'll need key information about what's happening—as it happens. You'll need to ask the right people the right questions. Work with your team to make sure the information is flowing. You'll also need to make sense out of the information you get. Sort out what's relevant, and what isn't; what's important and what's trivial. It's easy to get bogged down in details, so step back every now and then, and take a broad view of the situation.

At this phase of the crisis, it's important to have a sounding board—a person you can trust to help you talk through ideas, information, and decisions.

Analyze potential risks

With your group, brainstorm the costs for each risk you've identified. Consider everything that might go wrong, and assess the costs if it should. A risk analysis measures more than just costs in terms of money. Determine costs in terms of human health and safety, and other important factors such as ability to meet customers' demands, ability for employees to work and communicate efficiently, and the company's reputation.

Prioritize those that are most pressing, and deal with them first.

Come up with a crisis or contingency plan. Having selected a key what-if scenario and analyzed possible consequences, brainstorm the kinds of decisions that will have to be made. In the event of a natural disaster, employees may have to be evacuated. Second- or third- shift employees might have to be notified. If a problem arises getting a product to market, additional staff may have to be hired quickly, alternative methods of transportation might have to be lined up, or management may have to answer phones. In the event of an impending strike by transportation workers, you might decide to call in a team of employees who drive minivans to bring some people to work and arrange for some people to work from home.

As you go through this exercise, start to consider who should be making these decisions.

Explore the crisis plan's possible side effects. Perform a reality check on your plan by brainstorming possible side effects.

For example, when a chain of auto-repair shops wanted to boost sagging sales, management offered mechanics sales incentives. The more work they brought in, the bigger bonus they'd make. Unfortunately, some of the mechanics began recommending unnecessary repairs. Customers complained that they were being ripped off, and the chain's reputation suffered. Similarly, a factory offered incentives for every defective product turned in, but it soon turned out that some workers were deliberately damaging products in order to receive the awards. And when a pizza company promised to deliver their "pizza in 30 minutes or it's free," speeding drivers caused car accidents.

You don't have to cover every eventuality, but thinking things through carefully can help prevent problems.

Form a crisis-management team

The outcome of the crisis depends on the performance of the people making the decisions. The better prepared they are, the better the crisis will be handled.

Determine who on your team will

• be involved in handling each aspect of the crisis
• make what kinds of decisions
• notify authorities within the company
• notify employees, government agencies, media, and so forth
• decide if employees should stay home
• decide to evacuate a building
• decide to hire temporary personnel in the event of an unexpected business rush

Once these decisions have been made, make sure that every person on the team has a back-up in case they are unavailable.

Create and distribute a list of all phone numbers, e-mail addresses, and ways to reach critical team players. Have people put the list on their computers, in their mobile-phone address books, on wireless communicators, and in their home office . . . wherever anyone on the team could possibly need access to it.

Form a crisis network. Identify both formal and informal networks within the organization. Who are key players you may need to rely on in a crisis? Make it a point to establish relationships that you don't already have. When a crisis comes, it's a lot easier to handle if you already know all the players.

Recognize the risks

Consider a major investment company that had only one line of business—helping individual investors buy and sell stocks. When the investment market was at its peak, this company did a booming business. It poured its profits into expanding its business by hiring more people and opening more offices. But when the economy stalled and individual investors stopped buying, the company had no other sources of revenue. The company's stock dropped and they were forced to make huge layoffs which affected everyone in the organization. By exploring other sources of revenue, and investing some of its profits in those opportunities—and by doing some "what-ifs" about their rate of growth—the company may have lessened some effects of the disaster. Of course, some things are clear in hindsight, but important lessons are all around.

Use the results of your crisis audit as a basis from which to brainstorm potential crises. Question basic assumptions about your business—both the present, and the future. What assumptions do you have that might not be true? Ask yourself, "What would happen if people stopped buying our best-selling product?" or "What if demand for our product is so huge that we can't fill our orders?" It's important to do this as a group. Other people can provide a valuable perspective on each other's closely held assumptions. And finally ask, "How would this impact our group?"

Once you've determined what crises you need to plan for, consider ways to minimize these risks.

Preparing to Manage the Crisis

In business, creating a contingency plan means making as many decisions as you can before the crisis occurs, so that your energies can go into handling the crisis effectively when it does occur. Many of these tasks are fairly easy to do when things are going well, but difficult and stressful to do in the middle of a crisis.

However, just a as a hospital arranges for a standby generator in case power goes out during surgery, you need back-up plans for the set of crises you have identified as the ones your company or department must expect and prepare for.

Avoiding the Crisis

Crises that are handled poorly often get the greatest media attention. But we don't often hear much about crises that were prevented. Remember the Y2K bug? On New Year's Day, 2000, virtually every computer in the world made the calendar switch to the new millennium without a hitch. All those listening for trouble heard was the quiet sound of a crisis that had been prevented. For years, businesses had worked to solve the Y2K problem before it happened. And their efforts paid off.

Of course, managers at every level of an organization intercede and prevent minor crises every day.

• A sales representative notices that a client's name is misspelled on every page of a major sales proposal. The manager has all the copies destroyed, makes the adjustments, and has new proposals printed at an all-night copy center saving the company from losing a major account.
• A manager foresees a cash flow shortage, takes steps to hurry receivables, and makes sure a credit line is available at the company's bank should the expected cash still not come in.
• A manager who, when informed that a key employee is leaving, takes steps to find a replacement instead of leaving it to the last minute.

All these managers are actively involved in avoiding crises. It's their job.

Perform a crisis audit

Most managers are already attuned to possible and probable crises and take some steps to avoid them. But you can become even more effective by preparing for crises when things are going well. The first step is to perform a crisis audit. Look for things that are going wrong now or that have the potential to go wrong in the future.

A crisis audit may look like one more "To do" on your long list, but examining what has the potential to go wrong should not be just one more item to be squeezed into your already busy day but, rather, an important part of your company's or department's long-term plan.

A crisis audit involves the following steps:

Make crisis planning a part of your strategic planning. Incorporate the crisis audit into your part of the overall strategic planning process. Whether you run your own business or department, you still have to plan strategically for the future, and that planning needs to include crisis planning.

Get together and share ideas. People's perspectives about potential crises often differ greatly. No one person has all the information a company needs. By talking to people from other areas of your department, division, or company, you may get some surprising information. Work with colleagues in your department and in other departments to analyze your situation.

Perform the SWOT analysis from a crisis perspective. One useful strategic planning tool is the SWOT analysis (Strengths, Weaknesses, Opportunities, Threats). Conduct the analysis specifically from a crisis perspective—after all, crises often evolve from internal weaknesses or external threats.

What are your organization's internal weaknesses? Where might a crisis occur in your normal business procedures? For example, are you so understaffed that if one member of the team were to leave, you couldn't function? Or is your infrastructure old and patched together? Are you having quality control problems that could lead to consumer dissatisfaction or harm?

What are your most likely external threats? Which of those threats would be the most damaging to your company? Is your competition likely to introduce a radically new product, making yours obsolete?

Note: Often people refuse to recognize the one major threat that looms over the company. By ignoring the reality, any constructive action that might avert or lessen the impact of the problem is left undone. For example, if your company has been successfully producing one major product line, but the managers refuse to acknowledge a new, innovative product that will eventually make your entire product line obsolete, your company very likely will not survive.

Focus on the four major crisis areas. To break down your audit into manageable segments, focus on the four major areas where crises tend to occur.

• Health and environmental disasters: The health and safety of employees, consumers, the general public, and the environment are high priorities. Some of the most embarrassing and damaging crises have occurred when profitability or reputation is placed above health and safety. This type of crisis can escalate from a small problem to a major crisis quickly, particularly when people within the institution try to cover it up, place blame, or minimize its importance.

• Technological breakdowns: You probably already have a good idea of some of the biggest weaknesses in your company's or department's technology. Maybe it's the phone system, the server, or the Internet hook-up. Weaknesses in technology can precipitate paralyzing crises if left untreated.

• Economic and market forces: Economic forces and market swings can be crises with the greatest opportunities hidden inside—but only if you are prepared. Otherwise, an unexpected market swing can be damaging or even devastating.

  For example, consider a small, health-related dot-com at the height of the dot-com investment bubble. The development team invested an enormous amount of money in creating content that was provided for free on the company's Web site. Little money or resources were left to develop the subscription site—the part of the site that was actually set up to make a profit. The company was following the model of other Web-development companies at the time—giving away most of their content for free. And many of these companies went out of business, the ultimate business crisis! Why did this happen? The tiny dot-com might have failed anyway, but by following what everyone else was doing without questioning the business fundamentals, they guaranteed it. They ignored how they were going to make a profit once the venture capital money ran out.

• Relationships: People are unpredictable. Consider the fast-food company that sponsored a quiz game with a million-dollar prize. Unknown to anyone in the food company, the subcontractor in charge of printing and distributing the game pieces rigged the outcome of the game—over a period of several years—funneling the prize money to its employees and their friends.

  Clients can surprise you; for example, the advertising agency whose Fortune 500 client simply closed its doors. Millions of dollars worth of business were lost.

  As a manager, you have to deal with numerous and diverse relationships. Look for vulnerable relationships. Be particularly aware of the one vendor, client, or computer whiz whose sudden departure could ruin your company.

Develop your crisis-risk list. In performing the crisis audit, ask yourselves two basic questions:

1. What are the worst things that could go wrong?
2. What are the most likely or probable crises that could occur?

You can't possibly address every potential problem or crisis, and some crises simply won't touch your organization. For example, if your company is not located in an earthquake zone, don't put earthquakes on your crisis risk list. Or, if you are part of a consulting firm, you won't be worrying about a possible labor strike.

Narrow the crisis-risk list by focusing on the crises that would have the worst result, would be most likely to occur, and would affect your group.